Why Your Temperament Matters More To Your Portfolio Than Your IQ

I often hear from many new investors who fear that they don’t have the intelligence or aptitude to make good long-term investment decisions. They somehow have the impression that the best investment returns only go to the class valedictorian or the town heart surgeon. It’s simply not true. Your temperament plays a much larger role in your ability to successfully manage an investment portfolio than your test scores or educational background does. In fact, being too clever can be detrimental if it causes you to become overly confident and take risks that you would have otherwise avoided.

In his classic masterpiece, the 1949 edition of The Intelligent Investor, legendary portfolio manager and scholar Benjamin Graham went so far as to say, “-in the investor’s own mind and temperament – there is likely to be an urge, frequently unconscious, toward speculation, toward making money quickly and excitedly, toward participating in the moods and aberrations of the crowd. Let us repeat, therefore, that the genuine investor in common stocks does not need a great equipment of brains and knowledge, but he does need some unusual qualities of character.”

When I help my own friends and family invest their own money, there are a few rules upon which I constantly hammer, lest they ever forget them. These rules are much more important to good portfolio management than an ability to calculate the value of complex derivatives or do advanced pension accounting. Learn them, and consider using some or all of them in your own life to reduce risk and give your capital a fighting chance at compounding successfully for long periods of time.

1. Never Concentrate Your Entire Net Worth In One or Two Asset Classes

Each asset class has its own advantages and disadvantages. Disciplined portfolio management requires knowing what they are. Stocks beat every other asset class in the long-run on an after-tax after-inflation basis, but they can fluctuate wildly in the short-term. Bonds can provide stability if the duration is low but they can lose real purchasing power if the inflation rate increases. Real estate produces more cash flow than the other asset classes, but can’t grow in real terms near what high quality stocks can and often require leverage, which introduces additional risks. It is probable that, if you have at least a few hundred thousand dollars in assets on the your balance sheet, all three should be playing a role in your family’s finances.

2. Don’t Lower Your Standards for Safety and Return Just Because Values Are Hard to Find

When stocks, real estate, or bonds are overvalued, or credit quality has diminished, or other risk factors have been introduced, it can be a temptation to give up and buy something for the sake of activity. Don’t fall for this trap. Bubbles always inevitably pop and, in the meantime, there are always intelligent things to do. Even Sir Isaac Newton, one of the most brilliant men to have ever lived, was sucked into the speculative frenzy that was the Dutch Tulip obsession. Stick to your convictions. Stick to your demands. If you are risking your hard earned savings, you should be able to sleep at night knowing what you own, why you own it, and that you got a fair price and terms in the transaction.

3. Keep Your Costs Low So You Have More Capital To Compound

Every penny you pay in fees, commissions, spreads, and service charges such as the mutual fund expense ratio makes an enormous difference to your net worth. A percentage point here or there may not seem like much during the journey, but because of the cumulative effect of the awesome power of compounding, it can add up to hundreds of thousands, or even millions, of dollars in future wealth lost; cash that founds its way into the hands of bankers and Wall Street executives rather than your own family. It’s a needless tragedy that can be avoided with a little bit of diligence.

In some situations, fees can be worth the cost. If you have no idea what you are doing, approaching a highly regarded, conservative team of financial advisors who keep you from wiping out your capital, doing permanent damage to your net worth, is a tremendous bargain! Typically, the absolute maximum you should be paying a portfolio management team at a private bank or wealth management firm is 2% of net assets per annum.

4. Never Buy An Asset You Can’t Explain to a Kindergartner

If you can’t explain how an asset generates cash in two or three sentences, in simple enough terms that a kindergartner can understand it, you probably shouldn’t be making the investment. Life is full of uncertainties but, to the degree such things can be controlled, there is no reason you should be introducing them to your family’s income statement and balance sheet. Sure, this means you might pass on some amazing opportunities once in awhile. More often, it will keep you from losing your shirt.

Billionaire investor Warren Buffett once told a story in an interview of his reaction upon reading the Enron annual report and 10k. He said that even he, one of the most experienced and talented securities analysts on the planet, couldn’t make sense of the financial statements, which lead him to believe someone didn’t want him to understand the figures. Even though everyone else loved the company, he passed, never buying it for himself or his firm, Berkshire Hathaway. It’s a powerful defensive strategy that you should seek to emulate in your own life.